The power to decide interest rates and market interest rate determination

Theories on interest rate determination and limitations

There are many theories on interest rate determination in economics research. Classical interest rate theories suggest that the interest rate is determined by savings and investment. Savings and investment are affected by real factors such as time preference, patience, waiting, and marginal products of capital (Bohm-Bawerk, 1890; Fisher, 1930; Marshall, 1961). Therefore, the classical theories are actually the real interest rate theories represented by Bohm-Bawerk, Fisher, and Marshall.

Keynesian liquidity preference theory argues that interest rates are determined by the relationship between demand and supply in money markets, where central banks determine money supply and people’s preference for liquidity determines money demand (Keynes, 1937). Moreover, the preference for liquidity is affected by the degree of precautionary, speculative, and transaction motives. Robertson (1940) and Ohlin (1935) criticize Keynes’ theory that the interest rate is determined by the quantity of money. They propose the loanable funds theory, which states that the interest rate is the price paid for the right to borrow or access loanable funds, and the equilibrium interest rate is determined by the demand and supply of funds. The supply comes mainly from personal and business savings, government budget surpluses, and loans from foreign countries while demand comes mainly from personal credit, business investment, government budget deficits, and borrowing from foreign countries.

Hicks (1989) argues that interest rate determination is related to both goods and money markets simultaneously. That is, the level of income and interest rate will be determined simultaneously if the two markets attain equilibrium simultaneously, that is, the investment-savings and liquidity preference-money supply (IS-LM) analysis. In addition, financial instruments of various types and terms have different interest rates, which gives rise to theories on the term structure of interest rates. The theories are so called because they show that for securities with the same risk as liquidity, the term structure determines their interest rates while the theory of interest rate risk argues that security interest rates are determined by default risks, liquidity, and taxation.

From the above analysis, we find that theories on interest rate determination differ because they assume various perspectives in the analysis of interest rates and their role. For example, interest rate determination is a price issue from a market perspective while interest rates are a policy instrument from the perspective of macroeconomic regulation and control. From the perspective of credit and information, interest rates are determined by liquidity and risk. The difference in theory is the difference in hypothesis in the model. Furthermore, the various hypotheses reflect the differences in people’s recognition of the essence of the issue.

In fact, interest rates have the attribute of duality. On the one hand, as a price of money, interest rates are determined by the markets. On the other hand, as a policy instrument, the benchmark interest rate is determined by monetary authorities. Correspondingly, interest rate determination occurs on two levels: market and state. Interest rate determination at the state level is often manifested in adjustments to the benchmark interest rate by central banks; hence, indirectly affecting market interest rates for economic regulation. Interest rate determination at the market level is the focus of our next discussion.

The stated theories have a common limitation, which is they ignore the logical relationship between interest rate determination and interest distribution. Interest rate determination is the process of interest distribution while interest distribution is realized through games among economic agents. Marx (2004) argues that interests are the surplus value that loaning capitalists take away from entrepreneurial capitalists; moreover, this concept determines that interest rates cannot exceed the profit margin. Marx also notes that the value of interest rates depends on the proportion of total profit margins distributed among the loaner and the borrower. However, Marx does not address how the proportion is determined.

The fundamental purpose of economic activity is to maximize the interests gained through distribution. In the market, distribution is embodied in the proportion of the trade surplus among all parties involved. The manifestation of the proportions is the transaction price. The market interest rate is actually the transaction price of funds in the money market. Different market interest rates practically determine the difference in interests that each party obtains through the distribution. The mechanism of interest distribution emerges as a result of various power games. The determination of the market interest rate reflects the pursuit of economic interests by transaction agents based on their pricing power. The greater the pricing power, the more likely it is that an agent will gain favorable results in the determination process; consequently, the agent will obtain more interests. Market interest rates include the interest rates in both formal and informal financial markets (also called private financial markets). In the next section, we analyze the factors that influence the interest rate under different circumstances by establishing bargaining models for both lenders and borrowers.

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